Use it or lose it: Understanding required minimum distributions

Paper with words RMD required minimum distributions

For anyone with retirement savings, understanding what RMD means is a financial imperative. The acronym stands for ‘required minimum distribution’ and describes money that taxpayers must by law withdraw annually from tax-advantaged retirement accounts. You probably knew that already, but don’t risk complacence; if you have an IRA, 401(k), profit sharing plan or another type of retirement account, you need to know exactly how RMD guidelines apply in your situation.

RMD rules exist to prevent taxpayers from sheltering income now only to pass the money on tax-free later as part of an estate. By setting minimum required distribution levels, the IRS ensures that most savers withdraw and pay taxes on some of these assets during their lifetime – thus fulfilling the accounts’ stated purpose of funding retirement years.

RMD Triggers

Given that purpose, it’s logical that age and retirement status trigger RMDs. For IRAs (including IRA-based plans like SEP and SIMPLE), the magic number is 70½. After reaching this age account holders must take the initial RMD by April 1 of the next year, whether or not they are still working. That’s a little misleading though, since subsequent RMDs must be completed by the end of the year. This can necessitate taking two distributions in the initial year. For example, if you turn 70 ½ in 2019 and take the 2019 RMD in February of 2020, you’ll still have to take the 2020 RMD by December 31, 2020.

Those with a 401(k) or another employer-sponsored plan can choose to wait until retirement before taking annual distributions. If the account owner is still working at age 70½, the clock doesn’t start until the year of retirement, with the first RMD due by April 1 of the following year. There’s one important caveat though: If the account holder owns 5% or more of the business that sponsors the plan, RMDs kick in based on age alone just like an IRA.

Some savers build a nest egg using Roth-type accounts, which come with their own rules regarding mandatory distributions. Since the funds in a Roth IRA were contributed on an after-tax basis, account owners can let them keep growing indefinitely. No mandatory distribution requirements apply to a Roth IRA during the account owner’s lifetime.

Roth 401(k) accounts are subject to the same RMD rules as traditional ones – but there’s a simple workaround. Rolling over the balance from the Roth 401(k) into a Roth IRA allows account holders to hang onto their savings as long as they like.

Figuring RMD amounts and penalties

RMD amounts depend on a combination of account balance, owner age, beneficiary relationship and owner status. Plan custodians or administrators should calculate the RMD each year and inform account owners by January 31. Even so, it’s a good idea to verify the amount as taxpayers are responsible for taking the right amount. The IRS offers several different tables and worksheets for determining RMDs. Be sure to use the correct table and check your work, because the penalty for insufficient distribution is severe: You’ll owe the IRS 50% of any RMD amount that was not distributed by the applicable deadline!

Inherited accounts

Individuals who inherit a 401(k) or IRA – including Roth accounts – must begin taking RMDs the year following the original account owner’s death. If the account owner passes prior to taking the full RMD for the year of death, inheritors must take that distribution as well.

For the year in which the death occurs, the inheritor’s RMD is the amount that would have applied to the deceased account owner. RMD amounts in subsequent years are based on a number of factors including the inheritor’s relationship to the deceased, age and life expectancy of the inheritor, and age and life expectancy of the original account owner at the time of passing.

The ins and outs of RMD rules make it a tricky area of the tax code, and failure to comply brings consequences no taxpayer wants to endure. You can depend on the experienced professionals at HBP to help keep your tax strategy as cost-efficient as possible while fulfilling all your individual tax obligations. Contact us today to learn how we can help.